JPMorgan Chase says ongoing inflation and an outlook for sharply lower returns for investors means that retirees should toss the long-standing 4% rule. That’s the rule that says retirees can safely draw down their savings by 4% per year without having to worry that they’ll run out of funds before they die. Failure to toss this rule could mean having to cut back on your spending or even seeing your savings disappear. Instead the big bank advises drawing down no more than 2% or 3% of your nest egg each year. Consider working with a financial advisor as you plan for a worry-free retirement.
What Is the 4% Rule
The 4% rule was first articulated in 1994 by financial planner Bill Bengen. It calls for spending 4% of your retirement savings in the first year of your retirement and then adjusting that percentage each year for inflation. Doing that would have kept retirees from running out of money in every 30-year period since 1926, even when economic conditions were at their worst, according to Bengen.
For example, a retiree with $1 million in savings would withdraw $40,000 in the first year of his or her retirement. Because all subsequent withdrawals are adjusted for inflation, the same retiree would withdraw $41,200 in their second year of retirement if inflation was 3%.
Why It’s Time to Toss the 4% Rule
Earlier this year, however, Bengen said the 4% rule needs to be tossed. And the reasons for doing so are numerous. For one thing people are living longer. According to the Social Security Administration, the average man turning 65 today can expect to live until age 84.3. His female counterpart can expect to live, on average, until age 86.6. Research has suggested that millennials may live well into their 90s and beyond, so there’s even more pressure to make retirement savings stretch.
The 4% rule also doesn’t take into account individual savings rates. Millennials have the lowest participation rate when it comes to saving in an employer-sponsored plan and a recent report shows that 56% of them are less likely to save for retirement outside of work. That means that a significant number of young workers could come up short in retirement.
JPMorgan also advises retiring the 4% rule because of prospects for lower returns and higher inflation – “that all economists now see on the horizon” – means the 4% rule could be a prescription for serious financial trouble. While the S&P 500 earned on average 10% over the last 10 years, the bank’s recently published long-term capital market assumptions forecast a 60/40 portfolio returning just 4.3%.
As an example, the bank said there is a nearly 100% likelihood that a 60-year-old with a $30 million taxable portfolio would run out of money if she spent 4% of her portfolio (i.e. $1.2 million) for the next 30 years.
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What to Do Instead
Given the degree of variability in retirees’ spending habits and investment results, JPMorgan offered six factors to weigh as you develop a withdrawal strategy that is tailor-made for you.
Tax rates – What is your combined federal, state and local tax rate?
Financial commitments – Do you aim to leave a legacy or benefit your descendants?
Additional resources – Are you the owner of illiquid but unencumburded assets like real estate, trusts or an inheritance?
Healthcare expenses – How would you estimate your ongoing medical needs?
Life partners’ ages – A 65-year-old couple today faces a 72% probability that at least one will live to age 90 and a 44% chance that person will live to be 95 years old.
Portfolio composition – How much do you have in taxable versus tax-deferred (i.e. traditional IRA) versus tax-free (i.e. Roth IRA) accounts? If you have a concentrated position, you might need to earmark more to account for that risk so as to avoid jeopardizing your lifestyle. Perhaps you have a lot of embedded gains and will need extra funds to pay taxes when those are eventually sold.
Other analysts have also found alternatives to the 4% rule. A Morningstar study found that using an initial withdrawal rate of 3.3%, a retiree with a portfolio split equally between equities and bonds has a 90% probability of maintaining a positive account balance after 30 years. The heavier the portfolio’s equity position, the lower the initial withdrawal rate should be. A financial advisor can help you weigh your options based on your personal circumstances and goals.
Bottom Line
The prospect of continued high inflation and sharply lower market returns of 5% or less means that the 4% withdrawal rule needs to be substituted for a rule that calls for withdrawing 2% to 3%. Be sure to weigh all the relevant factors as you come up with a withdrawal strategy that fits your risks and estimated needs.
Tips on Retirement
A financial advisor can help you find creative ways to enjoy your retirement without spending more than 2% or 3% of your nest egg each year. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t have access to a 401(k), consider opening an IRA or a Roth IRA as a way to save for retirement.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid -- in an account that isn't at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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